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1 CAPITAL BUDGETING ISSUES IN FAST- GROWING ECONOMIES PRACTICAL APPROACHES TO ESTIMATE COST OF CAPITAL

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2 General Model where R f denotes risk-free rate, MRP the world market risk premium, SR specific risk of the investment, and A some additional adjustment. Four Different Models two inputs ( R f and MRP ) on the basis of worldwide markets are shared by all four models two other inputs SR and A differ across the models 1. The Lessard Approach 2. The Godfrey-Espinosa Approach 3. The Goldman Sachs Approach 4. The SalomonSmithBarney Approach Cost of Equity, Flexible Approach

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3 measures specific risk ( SR ) as the product of a project beta ( p ) and a country beta ( c ): where p and c capture the risk of industry and country, respectively. cost of equity when investing in industry p and country c is: p ( c ) is estimated as the beta of the industry (country) with respect to the world market, and no further adjustment ( A is assumed to be zero) SR The Lessard Approach

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4 Two adjustments with respect to CAPM: 1) Adjusting R f by the yield spread of a country relative to the U.S. ( YS c ) A = YS c 2) Measuring risk as 60% of the volatility of local market relative to world market ( c / w ) SR = (0.60) ( c / W ) where c and w are the standard deviation of returns of stock market of country c and world, respectively. cost of equity when investing in industry p and country c is: this model ignores the specific nature of the project, but all that matters is the country in which the foreign company invests The Godfrey-Espinosa Approach

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5 one adjustments with respect to Godfrey-Espinosa Approach : replacing 0.60 by one minus the observed correlation between the stock market and bond market of the country c. SR = (1 SB ) ( c / W ) where SB is the correlation between stock and bond markets. cost of equity when investing in country c is: intuition of the model SB = 0 no correlation, two sources of risk (stock and bond) SB = 1 YS c captures all relevant risk 0< SB